Saturday, October 25, 2008

The Mathematics of Losing Money

Here's a reminder of why you can't afford to let losses get away from you. A 10% loss means you need a bit more than an 11% gain to get back to even. At down 20% you need a 25% recovery, etc.Look at some recent stats on various markets with that thought in mind. From the Los Angeles Times Money&Co. blog:

Many World Stock Markets Now Off 50% or More from Peaks

Here's a club no country wants to join, yet its ranks are swelling: The 50%-Off (Or Worse) Stock Market Club.

Today brought another huge wave of selling in equity markets worldwide, as investors, understandably, keep focusing on the long list of negatives -- including still-severe credit market woes, forced asset sales by hedge funds as their clients bail out, and the likelihood of a deep recession ahead that will slash corporate earnings.

The wealth destruction around the globe from falling stock prices now has reached massive proportions....

A 70% decline requires a 233% up-move to break even. Using the Ibbotson 1926-2007 Large Company annualized return of 10.36%, it's going to take twelve years to get back to even. Unfortunately the 10.36% is the non-inflation adjusted number. The inflation adjusted average return is 6.7-6.8% meaning you'd have to compound at that 10.36% for over twenty years to get back to an equivalent buying power.

The only hope in this case is that the company underlying the stock is growing faster than the large company average. After its 89% fall 1929-32, the Dow Jones Industrial Average took until November 23, 1954 to regain its September 3, 1929 value of 381.17.

As you waited you would have collected dividends but they were more than offset by inflation, the buying power break-even wasn't until 1958. That is a grim reality, waiting half an adult lifetime to get back to where you were.

There are two bright spots though. After the current cyclical bear market decline has ended we get the secular bear market valuation contraction (i.e. broadly sideways as earnings growth doesn't goose prices), approximately eight years worth .

That's not the bright spot.

Following that, we can look forward to a 15-20 year secular bull market starting somewhere between 2015 and 2020. But, there will be opportunities all along the way.

Shorter term, the other bright spot is that returns coming out of these generational bottoms are some of the best the markets offer:

Best U.S. Stock Returns Born Out of Troubled TimesThree Best Periods to Enter the U.S. Stock Market Since 1926:

●Since 1926, the best five-year return in the U.S. stockmarket began in May 1932—in the midst of the GreatDepression—when stocks rallied 367%.

●The next best five-year period (when the stock marketrose 267%) began in July 1982 amid an economy in themidst of one of the worst recessions in the post-warperiod, featuring double-digit levels of unemploymentand interest rates.

Number three, following the Most Dramatic Fed Tightening in Past 20 Years